More Chinese Economic Support Likely Following Politburo's Rhetoric Shift

Beijing’s change in tone in acknowledging a weakening economy following the 25-member Politburo’s meeting on October 31 strongly suggests further government support is likely for the economy.

Looser monetary policy is likely, with an elevated probability of a cut to the 1-year benchmark lending rate.

From a fiscal perspective, we expect to see further measures reducing tax and import tariffs as well as increased export tax rebates, which will be positive for businesses, but we do not expect large-scale infrastructure spending.

The economy will likely continue to open up to foreign investment while efforts to curb financial risks and debt growth are likely to be dialled back.

Growth Target Still Paramount

China - Real GDP Target & Actual, % chg y-o-y

Source: NBS, NDRC, Fitch Solutions

The combined headwinds facing the Chinese economy from a domestically engineered slowdown to curb financial risks and rising US-China trade tensions will prompt further support from Beijing. Following a real GDP growth print of 6.5% y-o-y in Q318 – the slowest pace since the Global Financial Crisis (GFC) in 2009 – as well as sharp declines in business confidence and industrial profit growth, the central government is looking to adopt a more aggressive stance in terms of supporting the economy. This shows that Beijing still regards economic growth as the source of its political legitimacy. In terms of individual measures, we expect to see more monetary easing over the coming months and also an increasing likelihood of a cut to the 1-year benchmark lending rate. A looser monetary stance will put both downside pressure on onshore government bond yields, and also weigh on the Chinese yuan. From a fiscal perspective, we see more policies aimed at reducing costs for businesses and do not expect an infrastructure spending spree. While the authorities are likely to continue welcoming foreign investment inflows, the shift towards supporting economic growth suggests that the progress of certain areas of reform such as the curbing of financial risks and reining in debt, will slow.

In a statement released after a regular meeting of the 25-member Politburo chaired by President Xi Jinping on October 31, the government acknowledged that the economy was facing growing downward pressure amid profound changes in the external environment. It also stressed the need for greater attention to the problems facing the economy and for more pre-emptive policies to stem the slowdown. This marked a clear shift in language from the previous meeting in July, where a similar statement mentioned only noticeable external changes. That said, in the October statement, the government stressed its desire to maintain stability in the economy, which suggests that aggressive stimulus is still off the table.

Monetary Policy To Loosen Further, Greater Focus On Transmission

On the monetary policy front, we expect the People’s Bank of China (PBoC) to further ease credit conditions to alleviate the ‘increased difficulty facing businesses’ referred to in the meeting. While the central bank is likely to directly provide liquidity through its lending facilities, which include short-term reverse repos, the Medium-Term Lending Facility (MLF), as well as Pledged Supplementary Lending (PSL) to policy banks, a cut to the Benchmark Lending Rate is looking increasingly likely, despite it being the lowest it has ever been at 4.35% since 2015. We also expect the central bank to make the quarterly Macro-Prudential Assessments (MPA) more lenient for commercial banks and other financial institutions. This would improve the transmission mechanism of looser monetary policy, especially to small and medium enterprises, which are typically shunned by large state-owned lenders due to their higher risk profiles but are recognised by the government as a key pillar of the economy. This will likely take the form of a discount applied to risk accruing from outstanding loans to those businesses.

Further Tax Cuts, But Infrastructure Spending Spree Unlikely

On the fiscal side, we expect Beijing to continue its focus on the supply side reforms and reducing costs for businesses. This will likely take the form of further cuts to value-added tax, enterprise income tax and import tariff, as well as increasing export tax rebates. That said, we do not see a repeat of the infrastructure spending surge like the one seen in 2016. The authorities are likely to continue focusing on ‘high quality’ growth led by private consumption instead. Any increase in infrastructure spending will likely focus on amenities catering to an ageing population and in improving the quality of life for rural villagers instead of the rapid expansion of highways and railroads seen in the past (See ‘Residential, Non-Residential Growth To Subside As Prices Stabilise’, March 20). On the demand side, the authorities have cut income taxes effective from August for those in the lower income brackets (See ‘Chinese Policymakers To Speed Up Tax Cuts And Infrastructure Projects’, August 28). More measures boosting disposable incomes are also likely. On October 20, the authorities proposed more income tax deductions relating to expenses for accommodation, education and healthcare expenses and we expect these to come into effect over the coming months.

De-Risking Slowed In Service Of Support For Stocks

China - YTD Performance Of Major Equity Indices, %

Source: Bloomberg, Fitch Solutions

De-risking To Slow, But Foreign Capital Increasingly Welcome

We have previously warned that the Chinese government faces increasingly challenging policy trade-offs in meeting three competing objectives: supporting economic activity, preventing a significant pick-up in money supply growth and debt, and ensuring a relatively stable currency (see ‘Constraints To Prevent Aggressive Chinese Stimulus’, October 10). As such, greater support for the economy is likely to come at the expense of curbing money supply growth and financial risks, given the government’s unwillingness to allow a disruptive currency depreciation. There are signs that the de-risking campaign is already being slowed and even paused, in an effort to prop up investor confidence and ensure that growth meets the government’s 2018 growth target of 6.5%. For instance, On October 27 Beijing told lenders to avoid liquidating shares pledged as collateral to support the equity market, which has seen steep losses since the start of the year. Shanghai and Shenzhen stocks represented in the CSI300 equity index have fallen by more than 30% from their peak in January to close at 3,110 on October 31, a low not seen since the middle of 2016. In encouraging lenders to be more lenient, the authorities have assured them that risks associated with share-backed loans will not be part of their risk assessments, which goes against the campaign to reduce financial risks. Additionally, on October 19, the China Banking and Insurance Regulatory Commission also stated that it plans to start allowing products sold by the wealth management subsidiaries of commercial banks to be invested directly in the equity market.

Also in line with our view, Beijing has continued to signal its desire to open up the economy to foreign investment. The statement released after the meeting highlighted that China would continue to encourage foreign investment inflows, which will help to support investment growth. Besides that, doing so would also allow China to better manage commercial and trade disputes with its Western trading partners and reduce the economy’s reliance on debt (see ‘China To Continue Gradually Improving Investment Environment’, September 4).

Further Monetary Easing To Lower Bond Yields

China - 10-Year Government Bond Yield, %

Source: Bloomberg, Fitch Solutions

Looser Policies To Put Pressure On Bond Yields And CNY

In our view, these developments will likely further lower Chinese onshore government bond yields. After rising to test the 4.0% level of support in Q118, the 10-year government bond yield has eased steadily to trade at 3.5%, roughly coinciding with the steady implementation of easier monetary policy throughout the year. Given the likelihood of further easing, yields are likely to fall below 3.5% over the coming months.

Intervention In Forward Markets Anchoring Depreciatory Expectations

China - Spot & Forward Exchange Rate, CNY/USD

Source: Bloomberg, Fitch Solutions

Easier monetary policy will also likely weigh on the Chinese yuan, reinforcing our view for the currency to breach the key psychological level of CNY7.00/USD over the coming quarters. However, the pace of weakening is likely to be much more subdued, compared with the approximate 9% depreciation observed since the high of April. We expect the PBoC to continue intervening to prevent an uncontrolled and sharp depreciatory move, which was seen in 2015 as a result of significant capital flight. Indeed, the authorities have been intervening in the forward markets – essentially contracting to buy dollars today and sell them at various points in 2019 and we are forecasting the currency to average CNY7.10/USD in 2019 (versus the spot rate of around CNY6.97/USD).